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Active management without the headwindsVanguard Quantitative Equity Group
A tradition of active management When you think of Vanguard, you might first think
of indexing. However, The Vanguard Group, Inc.—
parent of Vanguard Investments Canada Inc.—began
operations in 1975 as an active investment manager.
Today Vanguard is one of the world’s largest active
managers, with more than $1.5 trillion managed
through both in-house and external advisors.1
As the firm’s in-house active equity manager,
the Quantitative Equity Group (QEG) developed
proprietary investing models that we first applied in
1991. Today we’re Vanguard’s fourth-largest active
equity manager with more than $45 billion under
management across 39 mandates.1 We apply
our investment processes to multiple strategies,
including traditional alpha, factors, liquid alternatives
and managed payout.
While our approach is active, we embrace the same
investing principles that Vanguard applies across all
of its products: clear goals, broad diversification, low
costs and long-term discipline. We also benefit from
the deep expertise of Vanguard’s global trading desk.
This is a distinguishing feature of our process,
because it enables us to implement our strategies
on a global scale at low cost.
1 As of March 31, 2017. All monetary amounts in Canadian dollars unless otherwise noted.2
How we think about investing Like all active managers, we don’t think markets are
fully efficient. We believe we can provide investors
with long-term value by systematically exploiting
market inefficiencies and anomalies arising from
investors’ behavioural biases.
While our approach is quantitative, we don’t rely on
high-frequency trading or pure technical analysis.
Our traditional alpha strategy, for example, evaluates
the economic prospects of firms through a bottom-
up, fundamental approach to security selection.
Our approach is also defined by what it seeks
to remove: the headwinds that can keep even
the most talented active fund managers from
succeeding. These include high costs that erode
returns, undisciplined portfolio construction that
can add unrewarded risk, and reliance on star
managers, which carries the risk of shifts in
strategy after they leave the funds.
Through rigorous risk management, discipline,
a team approach and an unyielding focus on
low costs, QEG reduces these headwinds.
Lower costs can boost performance
The potential benefits of low-cost active
management were substantiated in a recent
Vanguard study on U.S. mutual funds. The study
examined how a fund’s expense ratio and five
other fund metrics—turnover, tracking error, past
alpha, fund concentration and fund size—relate to
future risk-adjusted returns (or alpha).
The bars in the chart represent the difference in
alpha between funds in the lowest and highest
quartile of each metric. Of the six metrics, cost
was clearly the most significant indicator of
future alpha, with lower costs leading to higher
returns, on average.
Although cost isn’t the only determinant of future
alpha, it can be an effective filter to use when
you’re evaluating actively managed funds.
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edia
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erce
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ints
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Not statistically signi�cant
0.0
–0.5
0.5
1.0
1.5
Expense ratio
Turnover Trackingerror
Pastalpha
Fundconcentration
Fundsize
Notes: The bars represent the difference, measured in percentage points, in the median annual alpha from January 1, 2006, through December 31, 2015, of mutual funds in the lowest and highest quartiles based on the above metric measurements from January 1, 2001, through December 31, 2005. Fund concentration is measured as the percent of assets in the top ten holdings. The expense ratio and turnover were the only variables significant at the 99% confidence level. For more about the analysis, see Daniel W. Wallick, Brian R.Wimmer, and James Balsamo, Vanguard 2015. You get what you don’t pay for.Sources: Vanguard calculations, using data from Morningstar Inc.
Costs have been the dominant ex-ante signal
Why Vanguard hires usQEG operates as an in-house Vanguard manager,
but we vie for fund mandates alongside external
manager candidates. We’re vetted by Vanguard’s
Portfolio Review Department (PRD), which
oversees existing managers and recommends
prospective managers to a senior management
investment committee that includes
Vanguard’s CEO.
PRD hires us if it believes our capabilities offer
the best fit for a given mandate. Regardless
of the mandate we’re hired to manage, certain
hallmarks define our approach.
Rigorous research
Effective quantitative investing requires ongoing
research. While our core philosophy hasn’t
changed through the years, our dedicated team
of analysts continually tests and refines our
proprietary models to ensure they stay effective.
Our research efforts aren’t simply aimed at
producing higher returns. We also look to add
value in other ways, for example, by reducing
volatility or lowering transaction costs. We’ll
consider adding a new idea to our process if it
adds value and an economic justification exists
for why it adds value. An idea must also work in
different market environments, segments and
regions before we’ll adopt it.
Vigilant risk management
We keep a constant eye on risk in all of our
strategies. Our goal is to take only the proper
amount of risk to achieve an objective. For
example, in our global minimum volatility strategy
we don’t just look at volatility, we look at all
factors that can add risk. Then we add prudent
constraints around certain factors like industry
and country in an attempt to consistently provide
lower volatility than the market.
Idea generation
Is it: A philosophical �t? Economically rational? Sustainable?
Does it: Add value? Reduce risk? Lower transaction costs? Work in different market environments, regions and segments?
Proof of concept
Validation testingAttributionRisk monitoring
Implementation
Source: Vanguard.
New investment ideas undergo a rigorous vetting process
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In our traditional alpha strategy, we add constraints
in order to provide our investors with a measure
of performance consistency relative to the
benchmark. For example, since we rank stocks
among industry peers but don’t have a view on
industry, we choose to tightly control our industry
exposure. To help ensure we consistently capture
the premiums we seek, all of our strategies apply
additional constraints to preserve diversification,
maintain liquidity and limit issuer exposure.
We’re also subject to independent monitoring
by Vanguard’s Risk Management Group (RMG).
RMG monitors portfolio positions against limits,
undertakes attribution analysis, and works with
our portfolio managers to make sure risks are
identified and managed.
RMG’s reporting structure distinguishes our
approach to risk management. RMG’s head
reports directly to The Vanguard Group, Inc.’s
chief investment officer (CIO). This structure
keeps RMG close to our investment process and
ensures we’re aware of rapid changes to markets
and portfolios, along with their related risks and
potential effects on strategies.
Low costs
Vanguard’s enduring low-cost investment
philosophy is at the centre of every strategy
we manage. We keep costs low, in part, by
harnessing economies of scale from Vanguard’s
$5.7 trillion2 global asset management business.
For example, Vanguard uses its large global trading
volume to negotiate favourable pricing from brokers,
which helps keep our transaction costs low. And by
leveraging Vanguard’s regional trading hubs in the
U.K., Australia and the U.S., we can trade during
local hours when markets are most liquid, which
reduces market impact costs.
Consistent with Vanguard’s philosophy, we aim
to pass these savings on to investors. It’s a
simple, yet powerful idea: Investors earn more
when they pay less.
Tenured team with deep expertise
Our team is efficiently staffed with a deep
bench of credentialed professionals. Among our
26 strategists, analysts and portfolio managers,
12 hold the CFA designation and six have PhDs.
The team’s average Vanguard tenure is more
than 11 years. Our smaller size promotes close
collaboration among team members. Meanwhile,
we’re supported by the larger Vanguard organization
and leverage the best practices, low-cost execution
and expertise of equity traders in multiple markets
around the globe.
Our collaborative approach sets us apart from many
competitors. We seek to add value through low
costs, diversification and predictability relative to an
index, so we don’t have to rely on a star manager or
key individual. Since no single person is responsible
for all portfolio management decisions, investors can
be assured of continuity in our approach.
Discipline
We build disciplined portfolios with risk profiles
similar to an index, making bets only where we
think we can add value. We’re also disciplined
traders. Our proprietary investing models limit the
number of securities we need to trade, which
reduces transaction costs and helps preserve the
alpha we generate.
Discipline is present at every step of our process.
It defines how we hire our team, vet new ideas,
manage risk, trade securities and build portfolios.
2 As of March 31, 2017. 5
QEG puts its investing models to work across
several distinct strategies. The hallmarks of
our approach—rigorous research and risk
management, low costs, deep expertise
and discipline—are present in each strategy.
Traditional alpha
Our traditional alpha strategy seeks to achieve
long-term outperformance by finding stocks with
strong growth potential at a reasonable price.
Like many traditional managers, we select stocks
using fundamental, bottom-up criteria. The
difference is we apply our process quantitatively,
which allows us to execute at scale. Each night,
we pull in data on thousands of stocks from around
the globe. Our models use this data to calculate
the characteristics by which we evaluate stocks.
For us, attractive stocks exhibit four key themes:
• High quality. Companies should have healthy
balance sheets and consistent cash flow.
• Effective use of capital. Companies should
have sound investment policies. We prefer
internal to external funding.
• Strong sentiment. We should see market
and analyst confirmation of our view.
• Reasonable valuations. We avoid
overpriced stocks.
We generate an opinion on all stocks each day
based on the presence—and interaction—of the
four themes. Then we group stocks into industry
peer groups and rank them. We build our portfolios
by overweighting the most attractive stocks and
underweighting the least attractive.
1991
US large-cap value
US large-cap growth
US mid-cap growth
US small-cap growth
Total AUM xx billion
US large-cap value/incomeUS large-cap blend
Global energy sector
Global equityMarket neutral
US large-cap blend
Global minimum volatility
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Liquid alternativesGlobal liquidity
Global momentumGlobal value
2015
US all-cap blend
US small-cap blend
Managed payoutUS large-cap value
Traditional alpha Managed payout Factors Liquid alternatives
$45 billion
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Traditional alpha Managed payout Factors Liquid alternatives
U.S. large-cap blend
Global minimumvolatility
Liquid alternatives
Global liquidity
Global momentum
Global value
Global equity
Market neutral
U.S. small-cap blend
Managed payout
U.S. large-cap value
U.S. mid-cap growth
U.S. large-cap value/income
U.S. large-cap blendU.S. large-cap growth
U.S. small-cap growth
U.S. all-cap blend
Global energysector
U.S. large-cap value
Our quantitative strategies
QEG strategies and assets under management
6 Source: Vanguard, as of March 31, 2017.
Our process is designed to take advantage of
small mispricings. We spread our active risk among
many stocks, avoiding concentrated exposures to
individual stocks. Our process is also designed to
avoid unintended active risk versus the benchmark.
For example, while we take a position on stocks,
we remain neutral on industry.
Factor investing
QEG’s factor strategies aim to capture the return
premiums associated with factors including value,
momentum, liquidity and minimum volatility. We
target these factors globally because our research
shows they have historically produced positive
excess returns or other premiums (such as lower
volatility) across regions.
Although factor investing is inherently active,
many factor funds are managed to track an index.
Our approach is purely active, so we don’t have
to rely on a benchmark’s rebalancing schedule or
a benchmark provider’s definition and construction
of a factor. That means we can adapt portfolios to
maintain continuous exposure to factors, even as
markets and stocks change through time.
Our factor strategies are not only adaptable,
they are transparent. Our aim is to offer investors
the best of both worlds: flexible and efficient
targeting of the desired factors and a clear
understanding of how we construct factors
and assemble portfolios.
1991
US large-cap value
US large-cap growth
US mid-cap growth
US small-cap growth
Total AUM xx billion
US large-cap value/incomeUS large-cap blend
Global energy sector
Global equityMarket neutral
US large-cap blend
Global minimum volatility
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Liquid alternativesGlobal liquidity
Global momentumGlobal value
2015
US all-cap blend
US small-cap blend
Managed payoutUS large-cap value
Traditional alpha Managed payout Factors Liquid alternatives
$45 billion
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Traditional alpha Managed payout Factors Liquid alternatives
U.S. large-cap blend
Global minimumvolatility
Liquid alternatives
Global liquidity
Global momentum
Global value
Global equity
Market neutral
U.S. small-cap blend
Managed payout
U.S. large-cap value
U.S. mid-cap growth
U.S. large-cap value/income
U.S. large-cap blendU.S. large-cap growth
U.S. small-cap growth
U.S. all-cap blend
Global energysector
U.S. large-cap value
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Liquid alternatives
Our liquid alternatives strategy offers transparent
and low-cost access to non-traditional investments
and investing techniques. We aim to generate
returns that have low correlation with the returns
of the stock and bond markets, with less volatility
than the stock market. We use leverage and
long/short positions to implement five equally
weighted strategies:
• Event driven. We seek to capitalize on
price discrepancies and returns generated
by corporate activity such as mergers
and acquisitions.
• Long/short equity. We buy equities we
expect to increase in value and short-sell
equities expected to decrease in value.
• Currencies. We use forward foreign currency
contracts to benefit from currency movements
across countries.
• Fixed income relative value. We seek
to capitalize on perceived mispricing of
various liquid fixed income or interest-rate-
sensitive securities.
• Commodity-linked investments. We gain
long and short exposure to exchange-traded
commodity futures contracts, swaps and
other commodity-linked investments.
Unlike private hedge funds, we only use liquid
instruments that trade in well-established markets.
And since our strategy is offered as a mutual fund,
daily pricing allows investors to move in and out
with relative ease.
Managed payout
Our managed payout strategy is designed to
generate income in perpetuity, while preserving
capital over the long-term. The fund targets a
payout rate of 4% per year, paid out monthly.
To smooth out distributions, the payout percentage
is reset each year, based on the fund’s rolling
three-year average net asset value.
The fund employs a strategy similar to those
used by large endowments and foundations—
at a fraction of the cost. We actively manage
allocations across traditional and alternative
investments with the long-term goal of
preserving and growing capital.
This is a sophisticated endowment-style
strategy in mutual fund form. It can work equally
well for retirees seeking steady income or for
institutions seeking a regular source of funding
for operational needs.
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How we build a portfolio, trade, and monitor risk
Each day we evaluate our portfolios to determine
what trading may be necessary from a risk
and strategy perspective. For example, in our
traditional alpha strategy, we’d look for ways
to improve risk characteristics and add alpha.
Our preference is to trade with cash flow because
it reduces turnover, which minimizes transaction
costs. If cash flow isn’t available, we’ll buy and sell
within our portfolios, but only if we determine that
the investment benefit of a trade more than offsets
transaction costs.
Next we generate a trade list. Upon a successful
compliance review, we release the approved trade
list to Vanguard’s globally integrated trading desk.
They then work to execute the trades at the lowest
possible cost.
Risk monitoring is also built into our daily process.
We monitor risk within our own group, and
Vanguard Global Risk Management Group
independently monitors risk within our portfolios.
Optimizer generatestrade list
Risk monitoring
Daily monitoring alongside our enterprise-wide risk management team
Trading desk
Ensure trading ef�ciency
Execute trades
Evaluate
Evaluate
Trade list
Improve risk characteristics
Add alpha
Minimize cost
Optimiser generatestrade list
Risk monitoring
Daily monitoring alongside our enterprise-wide risk management team
Trading desk
Ensure trading ef�ciency
Execute trades
Evaluate
Evaluate
Trade list
Improve risk characteristics
Add alpha
Minimize cost
Our daily process
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QEG offers a disciplined, systematic and risk-controlled approach to active management.
When combined with Vanguard’s enduring low-cost approach, we believe we can reduce
the headwinds of active investing and deliver long-term value for investors.
To learn more about our strategies and products, visit vanguardcanada.ca.
Learn more about us
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QEG_CA 062017
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Date of publication: June 2017
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